US CPI Inflation falls, but less than the Fed is likely to have hoped for

Annual US year-on-year headline (or overall) consumer price inflation in January fell for the seventh month in a row to 6.4% from 6.5%, and core inflation (ex food and energy) fell for the fourth month in a row to 5.6% from 5.7%. While inflation thus was a little stronger than expected by many observers, it is evident that US inflation is slowing: headline inflation is at its lowest level since October 2021 and core inflation at its lowest level since December 2021. 

Figure 1. Headline inflation

Source: BLS. Data as of 14 February 2023.

Figure 2. Core inflation

Source: BLS. Data as of 14 February 2023.

The figures above illustrate that the behaviours of headline and core inflation are strikingly different. While month-on-month headline inflation has been very low since last summer, month-on-month core inflation has averaged 0.36% since October. That is far above the 0.17% month-on-month rate needed to lower inflation to the Fed’s 2% target. Thus, further disinflation will be needed before the Fed is likely to pivot.

As in the recent past, the reason inflation is not falling more rapidly is mainly that the shelter component remains very strong. It is a large part of headline (34%) and core inflation (43%) and continues to be very high (7.9% year-on-year and 0.7% month-on-month).

The shelter component differs from most other CPI components in that it reflects contracts entered in past months, as opposed to in January. Looking instead at the Zillow index for new rental contracts agreed in January, it is clear that there is little price pressure on new rental contracts (see figure below). This suggests that the rate of increase of shelter prices is likely to subside in coming months, lowering core, and therefore headline, inflation. 

The graph tells an interesting story. The largest sphere is that of energy commodities. While these have a minimal weight in the CPI, 4.9%, they are highly volatile.⁴ They therefore contribute disproportionally to movements in the CPI.

This is demonstrated in the graph below, which shows headline CPI inflation together with the annual percentage change in the index for energy commodities. The relationship is stunningly close (the correlation coefficient is 0.9). Indeed, as a first approximation almost all variation in CPI inflation is due to changes in prices of energy commodities.

Figure 3. Shelter, month-on-month

Source: BLS and Zillow. Data as of 14 February 2023.

Overall, inflation is falling in the US, but not as fast as the Fed would like. Expect further interest rate increases at the Fed meetings in March and May, and perhaps even in June.